How to Hedge Your Crypto Spot Position with Perpetual Futures

The crypto market is notoriously volatile, with Bitcoin alone swinging by as much as 10% in a single day. Holding spot positions in such a market can lead to massive gains—but also devastating losses. So, how can you protect your investments without selling off your assets? 

Traditional risk management techniques, such as stop-loss orders or portfolio diversification, may not be sufficient in the fast-moving crypto market. That’s where hedging with perpetual futures comes in. In this blog, we’ll explore how this strategy can effectively safeguard your spot positions and help you manage risk in the volatile world of crypto.

Key Takeaways

• What is Hedging?
• Hedging Strategy with Perpetual Futures
• The risks and rewards of leverage.
• How to calculate and manage risk effectively in crypto futures

What is Hedging?

The word “hedge” comes from the Old English word hecg, meaning a boundary or fence. In its modern financial context, hedging is essentially about creating a boundary around your investments to protect them from the unpredictable forces of the market.

Uncertainty is inherent in every market, and the goal of hedging is to reduce exposure to that uncertainty. Hedging works by balancing out risk with a second position that can offset potential losses. 

Read more about hedging here

What are Crypto Futures Contracts?

Crypto futures are contracts that let traders agree to buy or sell an asset at a set price on a future date. There are two main types: standard futures, which have a fixed expiration date, and perpetual futures, which don’t expire. 

Perpetual futures are popular among crypto traders because they allow continuous trading without time constraints, offering more flexibility to hedge positions or speculate on price movements without worrying about contract expiry.

You can read more about Crypto Futures Contract trading, here.

Example for Hedging Crypto Spots using Crypto Perpetual Futures

Here’s an example: Imagine you own 1 Bitcoin, and its current price is $40,000. This is your spot position. But since Bitcoin’s price is volatile, you’re concerned it might drop in value.

• To protect yourself, you decide to hedge using a Bitcoin futures contract. Let’s say you enter a futures contract to sell Bitcoin at $40,000 in one month.
• Now, if Bitcoin’s price drops to $35,000, your spot position loses $5,000 in value (1 Bitcoin x $5,000 drop). But since you have a futures contract to sell at $40,000, the value of that contract rises. If the futures price now moves up to $40,000, you can sell it for a profit of $5,000.
• In this way, the loss on your spot position ($5,000) is offset by the gain in your futures contract ($5,000), helping to protect your overall investment from the price drop.

How to Hedge Your Spot Position with Perpetual Futures: A Step-by-Step Guide

The goal is to neutralize risk in your spot position, essentially ‘locking in’ your position against unforeseen price movements. Here’s how you can do it

1. Identify your spot position: You hold 1 Bitcoin (BTC) at a price of $40,000. This is your spot position.
2. Open a short position in perpetual futures: You open a short (sell) position in Bitcoin perpetual futures at $40,000 to hedge against a potential price drop. This means you’re betting on Bitcoin’s price falling.
3. Price drops in the market: If Bitcoin’s price drops to $35,000, your spot position loses $5,000 (1 BTC x $5,000 drop).
4. Futures position gains: Meanwhile, your futures contract gains in value. The value of the futures contract increases as Bitcoin’s price decreases, and now you can buy back at $35,000, locking in a profit of $5,000.
5. Balance your risk: The $5,000 profit from the futures contract offsets the $5,000 loss in the spot position, protecting your overall investment.

How It Works in Different Market Conditions

• Bullish Market: If Bitcoin’s price rises, the futures position will lose value. However, your spot position gains value, potentially covering the futures loss.
• Bearish Market: As in the example above, when Bitcoin’s price falls, the short futures position gains while the spot position loses value, balancing the risk.
• Sideways Market: If Bitcoin’s price remains stable, your spot position doesn’t change much, and your futures position won’t see major fluctuations either. The hedge may not be as effective, but it can still protect against unexpected drops.

Using Leverage Wisely in Futures

• Leverage in futures can amplify both gains and losses. For example, using 2x leverage means you’re controlling 2 BTC with a 1 BTC margin.
• Risk management: Use lower leverage to limit exposure, especially if you’re new to futures. This way, you can reduce the risk of large losses while still benefiting from the hedge.

You can read more about Leverages here

Benefits of Hedging with Perpetual Futures

• Protects against market volatility by offsetting potential losses in your spot position.
• Allows profit in a downturn by shorting futures when the market drops.
• Offers flexibility with no expiration date, enabling continuous adjustments to your hedge.
• Reduces emotional trading by providing a protective strategy during volatile market movements.

Understanding Risk and Reward in Hedging with Perpetual Futures

Mastering the balance between risk, reward, and leverage is key to making your hedge truly effective. The essence of a hedge is to take a position that will gain when the market moves against your spot position.

Here are some examples that will give you a better understanding of how to hedge using perpetual futures.

Example 1: Basic Hedging

Let’s say you hold 1 BTC at $40,000 in your spot position.

Step 1: Identify the Risk

• If Bitcoin drops by 10% to $36,000, you lose $4,000 on your spot position (1 BTC × $4,000 drop).

Step 2: Hedge with Futures

• Now, to protect yourself, you enter a short futures contract at $40,000. This means you agree to sell Bitcoin at $40,000 in the future.

Step 3: If Price Drops

• If Bitcoin’s price drops to $36,000, you still lose $4,000 on your spot position, but your futures position now gains $4,000 (you’re short, and Bitcoin has fallen in price).

Mathematical Calculation of Profit/Loss:

• Spot Loss: 1 BTC × $4,000 = -$4,000
• Futures Gain: 1 BTC × $4,000 = +$4,000
• Net Position: -$4,000 + $4,000 = $0

In this case, your hedge worked perfectly, and your overall exposure to market risk was neutralised.

Example 2: Leverage in Futures Contracts

Now, consider the same scenario, but this time you use 2x leverage in your futures contract. With leverage, you’re controlling a larger position than the amount of margin you’ve put up.

Step 1: Identify the Position

• Spot position: 1 BTC at $40,000.
• Futures position: Short 1 BTC at $40,000 using 2x leverage.

Step 2: Impact of Leverage

• Without leverage, a 10% drop in Bitcoin’s price would cause you to lose $4,000 on your spot position. With 2x leverage, your futures position is worth 2 BTC, so the potential gain in the futures market is also magnified.

Step 3: Calculating the Futures Position

• The price drops to $36,000 (a 10% drop). Your spot position loses $4,000, but your leveraged futures position gains: Futures Position Gain=2 BTC×(40,000−36,000)=2×4,000=8,000Futures \ Position \ Gain = 2 \ BTC \times (40,000 – 36,000) = 2 \times 4,000 = 8,000Futures Position Gain=2 BTC×(40,000−36,000)=2×4,000=8,000

Mathematical Calculation of Profit/Loss:

• Spot Loss: 1 BTC × $4,000 = -$4,000
• Futures Gain (with leverage): 2 BTC × $4,000 = +$8,000
• Net Position: -$4,000 + $8,000 = +$4,000

Here, leveraging your futures contract has not only covered your spot loss but also resulted in a net gain.

Example 3: Over-Leveraging and the Risk of Losses

Let’s explore the potential risk of over-leveraging. Assume you use 10x leverage instead of 2x leverage.

Step 1: Identify the Position

• Spot position: 1 BTC at $40,000.
• Futures position: Short 1 BTC at $40,000 using 10x leverage.

Step 2: Impact of Leverage

• If Bitcoin’s price drops by 10%, your futures position would lose 10 times more than a non-leveraged position.

Step 3: Calculating the Futures Position with Leverage

• If Bitcoin drops to $36,000, your spot position loses $4,000, but your leveraged futures position (at 10x leverage) now loses: Futures Position Loss=10×(40,000−36,000)=10×4,000=40,000Futures \ Position \ Loss = 10 \times (40,000 – 36,000) = 10 \times 4,000 = 40,000Futures Position Loss=10×(40,000−36,000)=10×4,000=40,000

Mathematical Calculation of Profit/Loss:

• Spot Loss: 1 BTC × $4,000 = -$4,000
• Futures Loss (with 10x leverage): 10 BTC × $4,000 = -$40,000
• Net Position: -$4,000 – $40,000 = -$44,000

As you can see, leveraging too much can drastically increase both your gains and your potential losses. In this scenario, your future loss completely overshadows your spot position.

Conclusion

Hedging with perpetual futures is a powerful strategy, but it requires careful management of risk, reward, and leverage. To take your skills to the next level, consistently refine your approach, stay adaptable, and leverage the right tools. 

This is where Mudrex comes in. Mudrex offers a seamless way to manage your crypto portfolio, giving you the flexibility to experiment and optimize your strategies. Download the Mudrex app and get started with your crypto trading journey. 

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